Cost is an interesting term. It is something that is extremely common to discuss in many settings, business or not. We talk about the cost to make a product, the cost to have a meeting, the cost to process an invoice, or to acquire a new customer. My wife and I even discuss and debate costs related to cooking meals! I would offer, however, that the business world does not understand costs to the extent it believes it does. Also, I would offer we cannot regularly and easily discern the two types of costs and why some costs have absolutely nothing to do with cash. Let me demonstrate.
Let’s say I have a pen I’d like to sell to you. We agree on a price of $50. I sell the pen to you, you give me $50. There is a transaction with a clear exchange of cash. Now, as the person selling that pen, I, thinking like a cost traditionalist, would like to know how profitable the transaction was—how much money did I make? To determine this, I would have to calculate a cost and plug it into the profit equation.
The first problem is calculating the cost. As mentioned in the last chapter, there really is no single cost. One approach may result in a cost of $25, another $19.72, and have a third of $27.63. Let’s say for the sake of discussion, we use $25. Logically, if costs were tied to cash flow, there should be a $25 transaction representing the money involved in making that pen, and I should make $25 in cash after the transaction is completed. That doesn’t happen. Why?
To calculate the cost of my pen, I had to make assumptions and create relationships that don’t exist. I’ll give you an example. Remember way back in time when we used to have telephones hardwired into our homes? To get access to local phone calls, we would pay a local access fee. Assume the access fee for service is $25, and with this $25, we could make unlimited number of local phone calls. However, if we wanted to call someone outside of local area, we had to pay a long-distance fee. Let’s say the long-distance fee was $0.10 per minute. A 10-minute call would cost $1. Quick. How much would a 10-minute local call cost?
I bet you didn’t come up with that answer quite so quickly if you came up with one at all. Why? Because with long-distance calls, you were buying time, minutes, so there was a direct relationship between how many minutes you bought and what you paid. There is no such relationship between buying access and what you do with the access. This includes both making calls and attributes about the call such as its length in time or distance from you. The cost to you is $25, whether you make no calls or an infinite number of them as long as you are within the service area. To get the cost of a 10-minute local phone call, since no relationship exists, you have to create one—make it up. Since you’re making up this relationship, it is arbitrary. The only thing we know for sure from a cash transaction perspective is that the $25 has to be paid so that you can make a local calls. Once you go beyond this, you are headed into the realm of making up a false reality to calculate the cost of a call.
How much faith can you put into a number that was made up by creating an arbitrary relationship between two logically and mathematically independent things? How much value does it and can it have? You’d think none. Yet this is what we do every day.
Back to the pen. To calculate the cost of my pen, I will have to create a relationship that is similar to one that may be used when calculating the cost of a local call. What I pay someone who is making the pen has nothing to do with the pens they make if they are paid by the hour. It is based on how much access to them I buy. The cash transaction is tied to paying them for their time. Eight hours is more expensive to buy than seven. The same with materials. I buy materials and have them to create output—pens. As with labor, the price you pay for material has nothing to do with how it’s used, only its price and how much you buy. But to determine the cost of the pens, we must create an artificial relationship between what you bought, access, and how you used it, create output. This results in a mathematically false financial relationship between what you paid to have people, materials, and space to do work, and the cost value assigned to the work created by using them. The relationship created represents the consumption of labor, materials, space, and other factors, puts a dollar value on this consumption, and calls it a cost. The $25 represents one interpretation of the value of the inputs that are used to create the pen. When I make one more pen, am I giving someone $25? If so, to whom am I giving the money? If I don’t make the pen, does it mean I saved $25? No. These costs don’t just go away. I still have the people, the material vendor, and the lease to pay.
So what should you conclude from this? The reality is that there are two types of costs. One is the cost that involves an exchange of cash. After this exchange, you’re either richer or poorer, depending on whether you were giving or receiving the money. In other published materials, I have referred to this as cost as expense, and it is a cash flow cost.1 I will use the designation costC to reflect cash flow costs. The second cost is cost as effort, and this cost represents putting a monetary value on the consumption of space, labor, equipment, materials, and technology—things you buy in anticipation of demand or use. In this case, there’s no financial transaction, so there is no cash involved. Costs that have no cash value will be referred to as costNC, with the NC referencing the idea that it is not cash.
It is critically important that you understand the differences between costC and costNC. Because they’re both called costs, there is an assumption that they belong together logically, mathematically, and, therefore, financially. They do not. They’re very different values and they represent very different things, so combining them into one number and calling them all costs is a dangerous practice. Let me explain.
Practically all companies embark on efforts to manage or reduce costs. They buy expensive IT systems, invest in developing Six Sigma black belts, and focus on lean initiatives to improve financial performance; all to reduce costs. Executives claim savings opportunities that seem to be excessively large, such as $50–75 million just from transforming a finance group. This amount is used to cover the $25 million it costs to implement the software using your favorite big consulting firm. How often do these projects pan out as planned? How often do these huge business cases lead to the numbers they promise? These sometimes huge numbers should result in numbers you can see on your financial statements, right? That $3 million you saved because you can process invoices faster and have a cleaner general ledger should show up someplace. They do not nearly as often as the projects are approved. Why? Two reasons. First, the costs and cost savings were calculated and interpreted improperly. Second, these values, as a result, were not truly financial values. Let’s discuss both.
When calculating savings, if your costs were calculated using an arbitrary relationship between what you bought and what you created, the cost is related to the consumption of capacity and is, therefore, costNC. When you change how much capacity you’re using, it changes the value of costNC. If you use less capacity, the value of the capacity consumed does go down; hence you lower costNC. Recall, however, that the cost you pay to have access to capacity, costC, and what you do with it are independent. If you interpret this non-cash cost, costNC, as a cash cost, you will create a false and inflated savings opportunity.2
These calculated savings costNC, will often not be seen on the income statement. When looking to improve a process such as accounts payable using automation technology, you may improve costNC. However, the labor that may be improved is reported in aggregate as salary. Since the improvement will not affect salary, it will not show up on the income statement. It is possible that cost of goods sold improvements may show up on the income statement, but you will need to look at the entire picture. You can lower the average costNC for a pen by making a lot of them, but if your production exceeds demand, your margin on each pen sold may be better; but you may have spent an excessive amount of cash building what may be unneeded products. Consider this. How can it be cheaper to make 20 pens than it is to make five? More of everything is required. Of course, the costNC per unit is lower, but what does this mean? If there were demand for five, would you still choose to build 20? If not, why not, if it’s cheaper financially? If it is a financial value and it is better for you, why wouldn’t you choose to overproduce? Remember this thought.
By not understanding costC versus costNC, and by not acknowledging costNC has nothing to do with cash, you’re guaranteed to promise results you will not achieve. If you promise a total of $5 million in savings from your IT project, $1 million is costC and $4 million costNC, the cash potential is $1 million. If you assume they’re the same and you expect $5 million in cash, you will be disappointed. The cost that affects cash flow is costC. That is it. CostNC as a cash value is a mirage, and should not be considered equally with costC in cash flow discussions. They are as different as rocks and trees.
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1See, for example, Reginald Tomas Lee, “Making Better Offshoring and Onshoring Decisions,” Journal of Corporate Accounting & Finance, September/October 2014.
2Reginald Tomas Lee, “How we Overstate ROI on Improvement Projects” Cost Management, November/December 2015.